Chapter

9 Canada

Editor(s):
Teresa Ter-Minassian
Published Date:
September 1997
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Author(s)
Russell Krelove, Janet G. Stotsky and Charles L. Vehorn 

Sparsely populated and stretching from the Atlantic to the Pacific Oceans, Canada is a federal nation composed of heterogeneous provinces. The British North American Act of 1867 established the federal nation, which at that time consisted of only the four provinces of Nova Scotia, New Brunswick, Quebec, and Ontario. Subsequently, other provinces were added; the last was Newfoundland, in 1949. The Northwest Territories and the Yukon Territory were added to the federation at the end of the nineteenth century, but remain under the stewardship of the federal government. Today, Canada consists of 10 provinces, 2 territories, and nearly 5,000 local governments, including cities, towns, villages and townships, counties, and special service districts.

The Government Structure

The current relationship between the federal government and subnational governments can be traced back to the British North American Act of 1867, which enumerated the legislative powers of the federal parliament and the provincial legislatures. The federal powers fall broadly into the area of peace, order, and good government. The federal government is given responsibility for the national public debt and property, the regulation of trade and commerce, defense, money and banking, the criminal law, the raising of money by any type of taxation, and the authority to legislate in any areas not explicitly allocated to the provinces (Boadway and Hobson, 1993). The British North American Act of 1867 gives provincial legislatures the exclusive right to make laws within the province in areas that are generally local or private in nature, such as property and civil rights, public institutions (hospitals, asylums, prisons, and charitable institutions), education, the management and sale of public lands, and the administration of justice. Provincial government activities can be financed through the provincial right to use direct taxation. Provincial activities can also be financed by the “spending power” of the federal government. This power allows the federal government to make expenditures (usually through transfers) on functions under provincial jurisdiction (Clark, 1997). It is also important to note that this act does not contain provisions related to local governments. Instead, local governments are considered “creatures of the provinces” and receive their powers and responsibilities from the provincial legislatures. All provinces, for example, have devolved to local governments the responsibility for primary and secondary education, although in some provinces, responsibility is reverting to the province.1

Bird (1990) has pointed out that public sector financing in Canada is unique, because it is one of the most decentralized federations with respect to federal-provincial arrangements and one of the most centralized with respect to provincial-municipal arrangements. The drafters of the British North American Act of 1867 expected the federal government to maintain a dominant position over the provinces, with federal revenue and expenditures about three times those of the provinces. Over time, however, demand grew faster for those public services assigned to the provincial level, and they expanded relative to the federal level.

Table 1 presents government revenue (excluding intergovernmental transfers) as a share of GDP. Revenue of all governments has shown a persistent upward trend in this century, from 19.8 percent of GDP in 1939 to 43.3 percent in 1994. Until the late 1970s, federal revenue exceeded provincial and local revenue (excluding intergovernmental transfers), but since then provincial and local revenue has exceeded federal revenue.

Table 1.Canada: Government Revenue1(in percent of GDP)
FederalProvincial and Local2ProvincialLocalAll Governments3
(1)(2)(3)(4)(5)
19398.211.65.36.319.8
194321.96.93.33.628.7
195015.88.45.03.424.2
195517.18.44.73.725.5
196016.510.65.94.727.1
196515.813.18.64.529.0
197017.516.811.84.835.7
197518.517.213.04.137.4
198016.319.415.04.237.5
198517.420.516.24.140.0
199019.022.017.24.643.3
199418.722.217.05.043.3
Sources: Canadian Tax Foundation (1994); and Treff and Cook (1995).

Excluding intergovernmental transfers.

Including revenues of public hospitals. The difference between column (2) and the sum of columns (3) and (4) represents the hospital portion.

Including revenues of public hospitals, as well as compulsory contributions to and investment income of the Canada Pension Plan and the Quebec Pension Plan, which are excluded from the other columns. The public pension contributions amounted to 1.5 percent of GDP in 1970; by 1991, they amounted to 4 percent.

Sources: Canadian Tax Foundation (1994); and Treff and Cook (1995).

Excluding intergovernmental transfers.

Including revenues of public hospitals. The difference between column (2) and the sum of columns (3) and (4) represents the hospital portion.

Including revenues of public hospitals, as well as compulsory contributions to and investment income of the Canada Pension Plan and the Quebec Pension Plan, which are excluded from the other columns. The public pension contributions amounted to 1.5 percent of GDP in 1970; by 1991, they amounted to 4 percent.

Table 2 shows similar trends for expenditure. Expenditure of all governments has grown from 20.5 percent of GDP in 1939 to 48.6 percent in 1994. Federal expenditure increased dramatically around the time of World War II, then fell back to more historical levels. It then grew rapidly until the 1980s and has since stabilized. Federal grants to provinces (almost all grants go to provinces) have been relatively stable between 1970 and the mid-1990s, at around 4 percentage points of GDP. Provincial and local expenditure grew much faster than federal expenditure in the post-World War II period, owing to an increase in spending on the areas for which provinces and local governments are responsible. Resources are transferred to the provincial domain from the federal domain through intergovernmental grants and through shared taxes, most notably, the income tax. The growing gap between revenue and expenditure of general government has led to the accumulation of a sizable debt. This growth in the public sector and in the public debt has raised serious concerns about the ability of Canada to maintain its highly redistributive system of fiscal federalism.

Table 2.Canada: Government Expenditure(In percent of GDP)
Federal Including Grants to ProvincesFederal Grants to ProvincesFederal Excluding Grants to ProvincesProvincial and Local1All Governments2
19398.21.36.913.620.5
194339.11.337.86.744.5
195012.41.311.110.321.3
195516.41.514.910.725.6
196017.12.414.714.328.8
196514.92.412.616.328.7
197017.23.713.521.434.9
197520.84.416.423.139.9
198019.84.015.723.840.3
198524.04.519.426.046.8
199022.93.919.026.447.3
199422.64.118.527.448.6
Sources: Canadian Tax Foundation (1994); and Treff and Cook (1995).

Including expenditures of public hospitals.

Including expenditures of the Canada Pension Plan and the Quebec Pension Plan, which together amounted to 2.2 percent of GDP in 1991. Other columns do not include payouts under these compulsory public pension plans but do include pensions paid out of general government revenues (noncontributory schemes, funded from current taxes).

Sources: Canadian Tax Foundation (1994); and Treff and Cook (1995).

Including expenditures of public hospitals.

Including expenditures of the Canada Pension Plan and the Quebec Pension Plan, which together amounted to 2.2 percent of GDP in 1991. Other columns do not include payouts under these compulsory public pension plans but do include pensions paid out of general government revenues (noncontributory schemes, funded from current taxes).

The Constitution Act of 1982 amended and expanded the British North American Act of 1867. It gave constitutional standing to the principles of the welfare state that arose in Canada after World War II. Under the part of the Constitution Act devoted to “Equalization and Regional Disparities,” the federal and provincial governments are committed to promote equal opportunities for the well-being of Canadians, to further regional economic development, to reduce disparity in opportunities, and to provide essential public services of reasonable quality to all Canadians (Leslie, 1993). The act also reaffirmed the provincial taxing authority over nonrenewable resources, and instituted certain individual rights, for example, mobility, that could constrain provincial programs from imposing residency requirements. The net effect of this act on fiscal federalism continues to evolve. While one provision advocates reduction in regional disparities as a political principle, another section provides provinces with jurisdiction over nonrenewable resources, which could promote increased regional disparities because these resources are not distributed evenly across provinces.

At the time of federation, the provinces were given the right to provide for health and education. The twentieth century brought federal involvement into these areas, especially through providing grants to provinces and direct programs of income security to the population. The Constitution Act of 1982 reaffirms that the federal government is responsible for equalizing the ability of provincial governments to provide comparable levels of public services at comparable levels of taxation (Leslie, 1993). In this respect, Canadian federalism goes well beyond the redistributional objectives of the U.S. federal system.

To summarize, the last 40 years has seen a steady decentralization of fiscal expenditures in Canada from the federal to the provincial level, reflecting the rapid expansion of expenditures in areas assigned to the provinces, such as health and welfare. This expansion in provincial expenditure brought about a rise in provincial taxation and, until recently, increases in federal grants to the provinces. In recent years, federal grants as a share of GDP have fallen as the federal government has attempted to reduce its budget deficit.

Revenue Sources

The major tax revenue sources in Canada are the personal income tax, the corporate income tax, and the goods and services tax (a value-added tax enacted in 1991 to replace a manufacturers’ sales tax) at the federal level; the personal income tax and the corporate income tax (collected by the federal government but remitted in part to provinces), the retail sales tax, and resource taxes at the provincial level; and the property tax at the local level. Table 3 shows the percentage distribution of revenue for the federal, provincial, and local governments in fiscal year 1994.2 The British North American Act of 1867 gave provinces the power to collect direct taxes. Although a retail sales tax is generally considered by economists to be an indirect tax, Canadian law considers it a direct tax defined as a tax “demanded from the very person who it is intended or desired should pay it.” Provincial retail sales taxes are levied on the purchases and collected by the retailer on behalf of the government, so the sales tax is considered a direct tax Canadian Tax Foundation, 1994).

Table 3.Canada: Structure of Federal, Provincial, and Local Government Revenue, 19941(In percent)
Federal GovernmentProvincial and Local GovernmentTotal
Income taxes
Personal47.124.333.6
Corporate8.13.05.1
On payments to non residents1.00.4
Property and related taxes20.111.1
Consumption taxes
General sales14.012.413.2
Motive fuel2.53.63.3
Alcoholic beverages and robacco2.31.52.0
Customs duties2.51.3
Other0.60.20.4
Health and social insurance premiums14.20.19.7
Miscellaneous taxes0.32.81.7
Natural resource revenues3.52.0
Privileges, licenses, and permits0.32.91.8
Sales of goods and services2.87.55.3
Return on investments and other revenue4.412.19.1
Total consolidated own source revenue100.0100.0100.0
Source: Authors’ calculations based on data in Treff and Cook (1995).

Estimate.

Source: Authors’ calculations based on data in Treff and Cook (1995).

Estimate.

Personal Income Tax

The personal income tax has evolved over time. Before World War II, the personal income tax system in Canada was fragmented, with both the federal government and provincial governments levying their own taxes with separate bases, rate structure, and residency rules. During the war, the provinces agreed, on a temporary basis, to give up the right to levy the personal income tax and the corporate income tax, in return for cash transfers or “rentals.” Some provinces received tax transfers based on forgone revenue, and others received tax transfers based on the cost of servicing provincial debt, less revenue from death duties (Boadway and Hobson, 1993).

The tax transfer arrangement has undergone several modifications. In 1947, tax transfers were determined on the basis of equal per capita transfers, with various other provisions, such as a minimum yield provision. This modification implicitly brought the concept of equalization into the picture. Provinces that contributed less than the per capita national average would be equalized up to the national norm through a redistribution from those provinces above the per capita national average. However, both the provinces of Quebec and Ontario chose not to participate, under “opting out” provisions. Instead, they received 5 percent of federal personal income taxes collected within their borders.

In 1957, the notion of payments based on equalization was made explicit, along with the concept of fiscal responsibility. Each province received tax rentals based on revenues generated within its own border, initially 10 percent, along with a supplementary payment on the basis of equalization. This arrangement resulted in significant harmonization from a tax policy perspective, in contrast to a country like the United States (see Chapter 15), but prevented provinces from setting their own tax rate structure.

In 1962, the system of tax rentals was replaced with tax collection agreements, whereby the federal government gave tax abatements (or transferred tax room to the provinces). Each province received a standard uniform rate (percent) of federal taxes collected within the province. In addition, each province could set its own rate above the standard rate. Currently, nine provinces and two territories participate in this arrangement. Only Quebec collects its own personal income tax.

The nine provinces that participate in the tax collection agreement set their own tax rate as a rate on federal taxes, with the base defined as basic federal tax. Basic federal tax is different from the federal tax payable in that certain federal surtaxes and tax credits are excluded. Thus, provincial revenue is not affected by changes to the federal tax law outside the basic federal tax provision. This system maintains relative tax harmony while allowing each province to set its own tax-on-tax rate. Two other advantages of this arrangement are ease of administration and a relatively low compliance burden on taxpayers. One tax administration, Revenue Canada, collects both federal and provincial income taxes, allowing taxpayers to file only one return with a few additional lines added to calculate the provincial tax due. Table 4 presents, for 1995, the tax-on-tax rates for each province, which range from 45 percent to 69 percent. As Table 4 indicates, some provinces levy in addition surtaxes on basic federal tax, as well as a separate flat tax on net income.3

Table 4.Canada: Provincial Personal Income Tax Rates in Effect for 1995
Basic Personal Income TaxFlat TaxSurtaxes
Province(In percent of basic federal tax)(In percent of net income)(in percent of provincial tax payable)1
Newfoundland69.0
Prince Edward Island59.510.0 on amount payable over Can$12,500
Nova Scotia59.520.0 on amount payable over Can$10,000
New Brunswick64.08.0 on amount payable over Can$13,500
Quebecn.a.n.a.n.a.
Ontario58.020.0 on amount payable between Can$5,500 and Can$8,000

30.0 on amount payable over Can$8,000
Manitoba52.02.02.0 on net income over Can$30,000
Saskatchewan50.02.010.0 on sum of basic provincial tax and flat tax up to Can$4,000

25.0 on sum of basic provincial tax and flat tax over Can$4,000
Alberta45.50.528.0 on amount payable over Can$3,500
British Columbia52.530.0 on amount between Can$5,300 and Can$9,000

50.0 on amount payable over Can$9,000
Northwest Territories45.0
Yukon50.05.0 on amount payable over Can$6,000
Source: Treff and Cook (1995). n.a. = not applicable.

Except for Manitoba and Saskatchewan.

As a percentage of taxable income.

Source: Treff and Cook (1995). n.a. = not applicable.

Except for Manitoba and Saskatchewan.

As a percentage of taxable income.

Quebec has not participated in the federal government’s tax collection arrangements, and levies and collects its own personal income tax. In addition to certain federal tax credits, Quebec residents receive a tax abatement (transfer) of 16.5 percent of basic federal personal income tax.

Corporate Income Tax

The federal government collects the corporate income tax for seven provinces, excluding Ontario, Quebec, and Alberta. These three provinces collect their own corporate income tax on bases similar to the federal corporate income tax. The federal government provides a 10 percent tax credit to make room for the provincial corporate income tax. As with the personal income tax, provinces must use the federal tax base, but provinces determine their own tax rates and credits. All provinces provide a foreign tax credit, most provide a political contribution tax credit, some provide a research and development tax credit, and others provide a tax credit for the portion of provincial income tax that arises from the disallowance of natural resource royalties as an expense for federal income tax purposes (Canadian Tax Foundation, 1994).

In 1994, a basic federal income tax rate of 28 percent (38 percent before the provincial tax credit) was levied on general business, 21 percent on manufacturing and processing businesses, and 12 percent on small business. A 3 percent surtax was applied to federal tax, bringing the general rate up to 28.84 percent.4 The general corporate income tax rate for provinces varied from 14 percent to 17 percent, except for Quebec with an 8.9 percent rate for certain general businesses.

In order to ensure that corporations with permanent establishments in more than one province are not subject to double taxation, the profit of the consolidated organization is apportioned across provinces using an agreed rule. The allocation formula employed depends on the shares of sales and wage bill in any province. The amount of taxable income allocated to province i is given by

[½ (gross revenue in i/total gross revenue)

+ ½ (wages and salaries in i/total wages and salaries)] × taxable income.

The use of an apportionment rule of this sort reduces the incentive for corporations to engage in tax planning activities, such as transfer pricing, to reduce tax burden (Boadway and Hobson, 1993).

Domestic Indirect Taxes

The major indirect tax of the federal government is the goods and services tax (GST), enacted on January 1, 1991, which replaced an antiquated manufacturers’ sales tax (MST). The MST contained some elements of cascading and was applied only to a limited range of manufactured goods, neglecting entirely the service sector, and in its operation had the effect of favoring imports over domestically produced goods. Initially, the federal government proposed to merge the GST with provincial sales taxes to create a national VAT, which would be collected by the federal government and shared with the provinces. However, the provinces did not approve this initiative, so the federal government proceeded alone while continuing to carry on discussions with some provinces. The tax law eventually enacted provided for a single rate of 7 percent, a relatively broad base, and a threshold level of Can$30,000 in annual sales for small traders. Certain sectors, municipalities, universities, schools, and hospitals receive rebates so they would be no worse off under GST than they were under the MST.

The GST represents a significant improvement over the MST from a tax policy perspective; however, it strained intergovernmental relations because the provinces considered it a serious intrusion on their tax territory. The retail sales tax is the second most important revenue source for provinces (excluding property taxes, which are the primary revenue source for municipalities; see Table 3). All provinces except Alberta impose a retail sales tax, with rates varying from 6 percent to 12 percent. There are province-specific exemptions for certain goods, services, or types of purchasers. Food, prescription drugs, medical appliances, and most books are exempt in all provinces. Most provinces exempt certain purchases by municipalities (Canadian Tax Foundation, 1994).

The existence of two separate and different sales taxes has created many intergovernmental problems. The basic issue is designing a way to determine and allocate the provincial portion of GST revenues among the provinces. One compliance burden caused by the failure to obtain provincial approval of the GST is that businesses have to collect two separate sales taxes, provincial and federal, on different bases.5 Provinces east of Ontario chose to apply their sales tax to the tax-inclusive price, while the other provinces chose to exclude the GST from their sales tax base.

Quebec has agreed to harmonize its retail sales tax with the GST base and collect the tax on behalf of the federal government. This arrangement is the opposite of the traditional income tax agreements whereby the federal government collects tax on behalf of the provinces. In 1996, the provinces of Newfoundland, Nova Scotia, and New Brunswick signed an agreement with the federal government to harmonize the federal and provincial taxes, under which the combined federal-provincial tax rate would be 15 percent. The tax would be collected by a new agency that would involve provincial participation. Other provinces are still opposed to harmonization, although the federal government is continuing discussions on harmonizing the taxes.

Natural Resource Taxes

The federal government has little access to natural resources in the provinces as a revenue source. In the past, it had more access, either through special taxes on resources or indirectly through federal-provincial revenue-sharing agreements. However this access has been gradually ceded to the provinces.6

Differences in provincial resource revenues are a major source of interprovincial differences in revenue capacities. While natural resource revenue contributes over 3 percent of provincial and local government revenue (see Table 3), its importance is uneven. Natural resource revenue accounts for one-quarter of Alberta’s total general revenue and almost one-tenth of Saskatchewan’s. For the other provinces, however, it accounts on average for less than 2 percent of general revenue, and in several provinces it is insignificant (McMillan, 1991).

Other Taxes

The major tax at the municipal level is the property tax. In general, the base is real property—land or things erected on or affixed to the land (Canadian Tax Foundation, 1991). Depending on the province, property tax assessment is conducted by the provincial government, municipal governments, or independent provincial commissions. Assessment is not uniform because of differences in valuation methodologies, definitions of value, and frequency of reassessments. All provinces provide numerous exemptions either through provincial legislation or by authorizing municipalities to exempt certain types of property, such as educational institutions, churches, public hospitals, and charitable organizations. Property tax relief is also given, usually for the elderly. Property taxes are mainly used to support public education.7

Expenditure Responsibilities

The major areas of expenditure in Canada are social services, debt charges, and national defense at the federal level, and health, education, social services, and debt charges at the provincial and local levels. Table 5 shows the percentage distribution of expenditure for the federal, provincial, and local governments in fiscal year 1994.8 The British North American Act of 1876 laid out the basic expenditure responsibilities of the different levels of government. The federal government is responsible for goods and services with national scope, such as defense, international affairs, industrial policy, and research. The provincial and local governments have major responsibility for spending on goods and services that are local in nature, such as public education, health care, and municipal services.9 The two share responsibilities in areas where both have legitimate interests, such as agriculture, forestry, fishing, and public health.

Table 5.Canada: Structure of Federal, Provincial, and Local Government Expenditure, 19941(In percent)
Federal GovernmentProvincial and Local GovernmentsTotal
General services4.45.65.5
Protection of persons and property9.35.27.4
Transportation and communications2.25.94.6
Health4.921.813.5
Social services34.815.624.1
Education2.919.812.5
Resource conservation and industrial development3.94.24.1
Environment0.43.42.3
Recreation and culture0.82.82.1
Labor, employment, and immigration1.60.41.0
Housing1.20.81.1
Foreign affairs and international assistance2.31.1
Regional planning and development0.30.60.5
Research establishments0.90.20.5
Debt charges22.212.518.2
General purpose transfers to other governments6.7
Other1.21.41.4
Total consolidated expenditures100.0100.0100.0
Source: Authors’ calculations based on data in Treff and Cook (1995).

Estimated.

Source: Authors’ calculations based on data in Treff and Cook (1995).

Estimated.

In the post–World War II era, the federal government has expanded its activities in areas traditionally within the provincial preserve, especially in the area of the social safety net. The social safety net is complex, consisting of payments made directly to individuals and payments made from one level of government to another to support social safety net activities. The federal government provides a large proportion of transfers to individuals through assistance for the unemployed, family allowances, a universal old age pension, and national health insurance. The federal government also makes transfers to provinces to fund programs in postsecondary education, health care, welfare, and other areas. The rising spending on the social safety net has contributed to budgetary problems for both levels of government.

Overall, expenditure on health care, education, and social services has increased at about the same pace as GDP since the mid-1970s. Expenditure on education has decreased relative to GDP, and expenditure in the other two categories has increased (see Ip, 1991). Provincial-local expenditure on education was the most important function in dollar terms during the 1970s and until the mid-1980s. Nationally, local taxation accounted for about 35 percent of school revenues in 1989, with provincial funding contributing about 60 percent. In recent years, provinces have expanded their role in providing funds for primary and secondary education because of the inability of local governments to raise adequate revenues through the local property tax and because of a desire to equalize spending across local communities within a province.

Intergovernmental Grants

Intergovernmental grants became a significant part of the federal system in the period following World War II at the time that the federal government enacted several major social welfare programs, including unemployment insurance, family allowances, universal old age insurance, and national health insurance. The federal government intended that the latter two programs would be administered by the provincial governments, although it would retain overall control. However, some of the provinces resisted the federal design, and the federal government chose to fund the old age insurance program on its own (Leslie, 1993).

Over the subsequent decades, economic prosperity provided enough revenues for the federal government to expand its programs of family allowances and old age insurance, extend funds to postsecondary education, establish a program of revenue equalization, and fund many shared-cost programs with the provincial governments. In addition, in 1965, the federal government enacted the Canada Pension Plan, a program of compulsory public pensions that includes all provinces except Quebec. Quebec enacted its own plan, the Quebec Pension Plan, which is fully compatible with the federal plan (Leslie, 1993).

The major shared-cost programs introduced in the postwar years were the Medical Care Act and Canada Assistance Plan in 1966. In 1957, the federal government began sharing some hospital care costs with provinces. By 1961, all provinces had hospital insurance plans. The Medical Care Act was made available to any province that agreed to four basic criteria regarding coverage, administration, availability to residents, and portability. By 1971, all provinces had adopted acceptable Medicare plans. The federal grant was open-ended and matching, and varied by province according to per capita costs so that low-cost provinces received more than half their costs and high-cost provinces received less. The Canada Assistance Plan merged four shared-cost programs into one comprehensive program to provide aid to low-income elderly people, the disabled, unemployed people not eligible for unemployment insurance, and the blind. Although the federal government pays half of the cost of the program, the provinces design and administer their own programs. In the mid-1970s, as its fiscal position weakened, the federal government began to restructure the system of grants to provincial governments. In 1977, the Established Programs Financing Act merged hospital insurance, Medicare, and postsecondary education into a block grant, made on an equal per capita basis (Boadway and Hobson, 1993).

Federal funds are distributed by formulas aimed at the equalization of tax capacities, without any explicit attempt to measure expenditure needs in each province. It is implicitly assumed that expenditure needs are equal on a per capita basis. While the issue of expenditure needs has been discussed for many years between federal and provincial officials, no attempt has been made to build an assessment of expenditure needs into the transfer system, owing largely to the technical difficulties involved (Clark, 1997).

Fiscal Imbalances

According to the Conference Board of Canada, revenues as a share of GDP, in 1993 were greater than expenditures at both the federal and the provincial level and less than expenditures at the local level. Specifically, local level own source revenue is only 57 percent of own account expenditures, indicating that local governments are heavily reliant on the transfer system to meet their expenditure responsibilities (Clark, 1997).

While vertical imbalances are mainly significant at the local level, horizontal imbalances in Canada are more pronounced and are exacerbated by the abundance of (taxable) natural resources in a few provinces. Using fiscal capacity indices for 1994–95, Clark has shown that resource-rich provinces have substantially higher fiscal capacities than resource-poor provinces. For example, Alberta’s fiscal capacity index of 129.9 was almost twice as high as Newfoundland’s index of 65.6, before transfers. Equalization entitlement reduced this disparity significantly as Alberta’s fiscal capacity index fell to 122.6 and Newfoundland’s rose to 93.6.

Types of Grants

The federal government provides grants to subnational governments in two basic forms: general purpose transfers and special purpose transfers. The major general purpose transfer—equalization payments—is an unconditional grant to only those provinces with below-average tax capacity. The formula, based on 33 revenue sources, is discussed below. Until 1996, specific purpose transfers comprised the Established Programs Financing (EPF) and the Canada Assistance Plan (CAP). These programs expired at the end of fiscal year 1996, with a new program—Canada Health and Social Transfers—replacing them.

The EPF grants, made to all provinces on an equal per capita basis, contained a cash component and a tax component. Funds from this grant program were allocated solely to health care and postsecondary education. Even though the federal government required that the funds be spent in these two areas, as long as provinces continued to spend more than the allocated amount in both areas, the earmarking requirement could not be enforced.

Transfers under CAP were open-ended and matching, at a 50 percent rate. Assistance was provided to needy persons who are old, blind, disabled, or unemployed, dependent children, or native people, as well as to welfare providing institutions such as nursing homes, homes for unmarried mothers, hostels for transients, and child care institutions. Federal funds covered the costs of direct financial assistance, welfare services, and administration, but did not cover capital costs, or the costs of plant and equipment. The CAP offered a great deal of flexibility to provinces in that they could choose which categories of assistance they would provide. The federal government did not require any means testing, so eligibility was based only on the subjective concept of “need.”

Table 6 presents the estimated federal cash and tax transfers, which total almost Can$42 billion for 1995–96. Equalization, EPF, and CAP account for 87 percent of the Can$28.9 billion in cash transfers. Additionally, EPF tax transfers account for 91 percent of the Can$13.0 billion in tax transfers.

Table 6.Canada: Estimated Federal Payments to the Provinces, Territories, and Municipalities, 1995/96(In millions of Canadian dollars)
Cash transfers
General purpose transfers
Equalization8,870.0
Statutory subsidies38.1
Public utilities income tax transfer63.0
Youth allowance recovery−435.2
Territorial financial agreements1,163.8
Grants in lieu of property taxes435.3
Total general purpose cash transfers10,135.0
Established programs financing
Insured health services6,891.4
Postsecondary education2,184.6
Total EPF cash transfers19,076.0
Other specific purpose transfers
Canada Assistance Plan7,226.9
Other2,237.8
Total specific purpose cash transfers218,540.7
Total cash transfers28,886.9
Tax transfers
EPF tax transfers
Insured health services8,041.4
Postsecondary education3,805.7
Total EPF transfers11,847.1
Contracting out tax transfers
8.5 personal income tax points for EPF
5.0 personal income tax points for CAP725.9
3.0 personal income tax points for youth allowances435.2
Total tax transfers13,008.2
Total cash and tax transfers41,895.1
Memorandum items (equalization associated with EPF tax transfers
(included in line 1)):
Insured health services550.3
Postsecondary education260.4
Sources: Treff and Cook (1995), based on estimates; and Department of Finance calculations of entitlements under equalization and EDF, October 1995.

Excludes the equalization associated with the tax transfets, already included in line 1.

Includes Can$211.2 million not allocated by provinces.

Sources: Treff and Cook (1995), based on estimates; and Department of Finance calculations of entitlements under equalization and EDF, October 1995.

Excludes the equalization associated with the tax transfets, already included in line 1.

Includes Can$211.2 million not allocated by provinces.

Equalization

In Canada, the principle of equalization is part of the Constitution and receives broad support. The three major transfer programs until 1996—equalization payments, EPF, and CAP—attempted to equalize on different bases: capacity, population, and need. The formula for equalization payments distributes federal funds only to the seven “have not” provinces (Newfoundland, Prince Edward Island, Nova Scotia, New Brunswick, Quebec, Manitoba, and Saskatchewan). These provinces have below-average tax capacities defined as the difference between the per capita revenue raised for each specific revenue source on a national basis and the per capita revenue raised by the province for each specific revenue source, using a national average tax rate. The 33 revenue sources include income taxes, payroll taxes, general sales taxes, various excise taxes, resource revenues, property tax revenues, and so on. The formula, initially based on the national average, was called the representative national average standard (RNAS), It was later changed to the representative five-province standard (RFPS), which includes only British Columbia, Manitoba, Saskatchewan, Ontario, and Quebec. The actual formula is:

where

  • Eij = entitlement under revenue source j in province i,

  • BRj = the tax base for revenue source j in the five provinces,

  • PR = the population in the five representative provinces,

  • Bij = tax base for revenue source j in province i.

  • Pi = the population in province i, and

  • tj = the national average tax rate for revenue source j:

  • tj = iTRij/iBij

where TRij is the actual tax revenue collected from revenue source j in province i.

The equalization grant program embodies gross equalization, in the sense that the have-not provinces are equalized up, while the have provinces are not equalized down as would occur under a net equalization formula. Some redistribution from the have provinces occurs since relatively more of the federal funds came from these provinces, which pay proportionately more in federal taxes (Boadway and Hobson, 1993).

The impact of equalization payments is considerable. Table 7 shows per capita payments to the provinces in 1990/91. Before equalization, the per capita national revenue of the low income provinces varied between 63 percent and 88 percent of the national average. After equalization payments these provinces received 93 percent of the new, higher national average revenue, with a commensurate fall in the relative position of the higher-income provinces. While the equalization formula lowers revenue differentials, it does not, however, eliminate them. In addition, equalization payments equalize revenues, not services; that is, no account is taken of differences in needs (arising, for example, for demographic reasons, or because of differential costs of delivering services).

Table 7.Per Capita Federal Grants to Provinces, 1990/91(In billions of Canadian dollars)
ProvinceNational Revenue Yield1EqualizationEstablished Programs FinancingCanada Assistance Plan2
Newfoundland2,8981,686757177
Prince Edward Island2,9891,596757184
Nova Scotia3,5181,067757177
New Brunswick3,2961,288757221
Quebec3,973611757251
Ontario5,086757199
Manitoba3,737867757179
Saskatchewan4,059525757152
Alberta6,306757213
British Columbia4,808757236
Source: Boadway and Hobson (1993).

The revenue that would be generated using average national tax rates.

Fiscal year 1989/90.

Source: Boadway and Hobson (1993).

The revenue that would be generated using average national tax rates.

Fiscal year 1989/90.

The formula for EPF was based on the equalized value of tax transfers and a cash transfer that brought the full transfer up to an equal per capita allocation, that is:10

Total cash transfer = total entitlement − equalized value of tax transfer.

In fiscal year 1996, the federal government gave each province an equalized tax transfer of 13.5 percentage points of basic federal personal income taxes and 1 percentage point of taxable corporate income for EPF.

Table 8 shows the per capita growth in the three major transfer programs from 1980/81 to 1992/93 as well as the split between tax transfers and cash transfers. Equalization, which is a general purpose grant, and EPF, a block grant, grew by 98 percent and 84 percent, respectively. However, the CAP, an open-ended matching grant, grew by 180 percent. The federal government has limited the growth in equalization payments to the growth in GNP. The growth of EPF has also been limited since the 1980s. In the late 1980s, the limit was the rate of growth of GNP less 3 percent. In 1990, the federal government froze EPF transfers at their 1989 per capita levels for two years and extended this freeze for three additional years in the 1991 budget. As a result, the transfers grew only with population growth. Since the limit applied to overall EPF transfers and the tax points continued to grow, the cash component of the EPF fell significantly.

Table 8.Canada: Major Federal Transfers to Provincial Governments(In Canadian dollars per capita)
Established Programs FinancingCanada Assistance Plan
EqualizationCashValue of tax pointsTotalCashValue of tax pointsTotal
1980/61155.5213.1194.6407.780.112.192.2
1982/83181.1235.1218.2453.392.413.7106.0
1982/83198.1261.8241.6503.3117.114.1131.2
1983/84210.7301.0244.3545.3133.913.9147.8
1984/85216.4318.0265.3583.2142.915.0157.9
1985/86205.0335.1288.0623.1154.516.3170.8
1986/87228.5343.9315.2659.1160.517.4177.9
1987/88258.6339.4350.4689.8170.319.7190.0
1988/89281.3342.6378.7721.3178.820.2198.9
1989/90298.4342.8415.2758.0196.522.1218.6
1990/91303.6330.1427.9758.0206.923.9230.8
1991/92301.1315.1437.1752.2221.924.6246.6
1992/93307.3294.2458.0752.2232.825.3258.1
Source: Leslie (1993).
Source: Leslie (1993).

Growth in the CAP was difficult to constrain because of its open-ended nature. The program was little changed since its inception. However, in 1990, the federal government capped the annual rate of growth of CAP transfers to British Columbia, Alberta, and Ontario at 5 percent. Although this was challenged, the Canadian Supreme Court upheld the federal right to restrict the program. This was extended in 1991 for three years (Boadway and Hobson, 1993).

The February 1994 budget set a joint ceiling on EPF transfers for postsecondary education and CAP transfers. In the 1995 budget, the government chose to combine the CAP and EPF into a single block grant, termed the Canada Health and Social Transfer (CHST), effective in 1996/97. The government postponed defining a formula that would permanently set the size and allocation of the CHST after 1996/97. This new transfer retains the combination of cash and tax transfers. The total entitlement for each is based on national average EPF entitlement and individual CAP cash transfers in an earlier year. The growth of the total entitlement is still linked to national average per capita GDP. From this base, the value of the tax abatement and associated equalization are deducted to arrive at the cash transfer. The federal government has set a floor on cash transfers (Perry, 1996). The system of equalization grants was not amended.

Intergovernmental grants in Canada have a powerful influence on spending. All together, these grants lead to a significant equalization of fiscal capacities across provinces, although they do not entirely eliminate differences. As previously noted, the equalizing formulas do not take into account cost and expenditure need differences. To the extent that services are more costly or there is a greater need for services in some provinces, the grants formulas do not make any explicit provision for these differences. Moreover, the numerous caps on funding imposed by the federal government over the last few years have clearly made long-term budgetary planning more difficult for the provinces.

Local governments are heavily dependent on intergovernmental transfers from the provincial governments and to a lesser extent from the federal government. Most of the grants from provincial governments are in the form of conditional grants for education, health, social services, transportation, and other uses. The remainder are unconditional grants. The mix varies from province to province, depending on the split between provincial and local responsibilities. The major category of conditional grants is for education, which are provided in all provinces except New Brunswick (where funding is entirely a local responsibility). These grants take the form of direct funding and revenue pooling. Typically, education transfers have a redistributive element built into them to equalize the ability of different local jurisdictions to pay for education (Boadway and Hobson, 1993). This, too, is an area where change is occurring.

Borrowing

The size of the public debt has risen rapidly, leading to a heavy debt-service burden for both the federal and provincial governments. This has caused considerable public concern and retrenchment at the federal government level. The federal government began to experience serious budget problems in the mid-1970s, in the aftermath of the first oil shock. These problems continue to the present. Table 9 provides figures on the evolution of public debt in recent years. Federal debt was 70.8 percent of GDP in 1994, up from 33.2 percent in 1980. Provinces also face a heavy debt overhang, although not of the same magnitude as the federal government. Provincial debt was 22.7 percent of GDP in 1994, up from 4.9 percent in 1980. Recently, however, many provinces have introduced debt targets as part of their consolidation efforts. Consolidated public sector debt was 97.1 percent of GDP in 1994, up from 45.5 percent in 1980.

Table 9.Canada: Public Sector Debt(In percent of GDP)
FederalProvincialLocalConsolidated Public Sector
198033.24.97.445.5
198545.98.04.258.1
199054.611.73.069.3
199367.120.23.490.6
199470.822.73.697.1

Institutional Features

The federal government can borrow funds for current and capital purposes with no formal constitutional restrictions. The provincial governments can also borrow funds for current and capital purposes with no formal constitutional or federal government restrictions. They are not required to balance their current budgets annually, as is typical in the United States. Alberta, in fact, allows short-term borrowing for current operations up to the amount of the estimated tax revenue for the year. Table 10 provides figures on budget surpluses and deficits in recent years. The federal government and the provinces are subject to some market discipline as their debt is rated by one or more international investment firms, and these ratings are critical in creating a favorable environment for borrowing. In recent years, several of these ratings have been downgraded in response to the large deficits and accumulation of public debt.

Table 10.Canada: Government Surplus/Deficit (+/−)1(In percent of GDP)
FederalProvincial and LocalCanada and Quebec Pension PlansConsolidated Public Sector
1980−3.4−0.41.0−2.8
1985−6.6−0.90.7−6.8
1990−3.9−0.50.3−4.1
1993−4.9−2.2−0.2−7.3
1994−3.8−1.2−0.3−5.3
Source: Treff and Cook (1995).

All figures include intergovernmental grants.

Source: Treff and Cook (1995).

All figures include intergovernmental grants.

The federal government has several sources of borrowing. The major portion of federal debt is borrowed in the traditional bond market (both in Canada and abroad) and consists of marketable bonds, treasury bills, Canada savings bonds, Canada bills, and other debt liabilities. In addition, federal debt consists of borrowing from the Canada Pension Plan (CPP) and from public employee pension plans.

The provincial governments have two major sources of borrowing—the traditional bond market and the CPP. The CPP uses its surplus above current needs to purchase preferentially rated securities from the provinces. The CPP, along with provincial pension plans and provincial government entities, held 56 percent of the outstanding bonds and debentures of provincial governments in 1990 (Canadian Tax Foundation, 1991). Some provinces use the CPP funds themselves, while others act as a conduit for municipal debt.

Unlike provinces, municipal governments are required by the provinces to balance their budgets on a current basis. All provinces, however, provide some type of assistance to local governments in their borrowing activity through public intermediaries (municipal finance corporations) or matching grants. Municipal capital expenditures that involve long-term borrowing must be approved by the province. Many provinces require that local governments submit a capital budget extending over more than one year. Some provinces place limits on total, long-term, or short-term borrowing for the current budget, or some combination of limits to a certain proportion of taxable assessment, the estimated annual tax yield for the locality, or the current budget (Canadian Tax Foundation, 1991).

Macroeconomic Management

Budgets are cyclically sensitive on both the revenue and expenditure sides. Typically, income-based taxes are the most cyclically sensitive form of revenue, although broad-based consumption taxes also exhibit strong cyclical sensitivity. Certain components of expenditure are also cyclically sensitive, especially income transfer and social insurance programs. Interest payments on debt may also exhibit cyclical sensitivity in response to changing market interest rates.

As in other industrial nations, the federal budget has been used as a tool of macroeconomic management in the period following World War II, although in recent decades the rapid rise in government spending not matched by an increase in revenue has led to large structural deficits and a high debt burden. Unlike in the United States, where states impose limits on their ability (and the ability of local governments) to run budget deficits on their current accounts, provincial governments in Canada have more scope for running deficits. This has led not only to a heavier consolidated public debt burden but has also complicated the task of fiscal stabilization for the federal government, because, in principle, the provinces can conduct their own fiscal management, in line with objectives not necessarily compatible with those of the federal government.

The latter, however, has some control over provincial budgets on both the revenue and spending sides. To some commentators, the federal government’s motive in expanding its control over the income tax in the early postwar era was to enable it to implement a Keynesian fiscal policy. If the federal government had exclusive access to those revenue sources that were most susceptible to cyclical fluctuations—mainly the personal and corporate income taxes—it would be better able to fine-tune surpluses or deficits as Keynesian principles might prescribe. At the same time, it would be able to shelter the provincial governments from any sudden drop in revenues by financing a large portion of their activities through federal grants. It was thought that the effect would be stabilizing not only over time but also among regions (Leslie, 1993). However, this scheme never fully succeeded because some provinces resisted incorporation into it, most notably Quebec. Subsequently, the federal government transferred some income tax authority back to the provinces, resulting in the current arrangement whereby the government collects the personal income tax for nine provinces and the corporate income tax for seven provinces and transfers it to the provinces. Even the nonparticipating provinces have relatively harmonized personal and corporate income taxes. As a result, the federal government still retains significant control over income taxes.

The cyclical sensitivity of tax revenue also depends on broad-based sales taxes and property taxes. As with the personal and corporate income taxes, the federal government does not have exclusive use of broad-based sales taxes, sharing this authority with the provinces. The switch from the MST to the GST at the federal level has probably acted to reduce the cyclical sensitivity of sales tax revenue. The GST base is broader than the MST base, by including more services and value added of the distribution sector. This would tend to reduce the cyclical sensitivity of the tax, since a more comprehensive measure of spending is likely to be less volatile than one just based on sales of manufactured items. Property taxes are typically less cyclically sensitive than broad-based income or consumption taxes. They move with the business cycle, but generally with a lag. Their concentration at the local and provincial levels is likely to make the provincial and local tax bases less cyclical overall.

Spending on social welfare programs is largely shared between the federal and provincial governments. The cyclical component would come in largely through the individual transfer programs rather than the intergovernmental grant programs, since none of the major intergovernmental grants has an explicitly cyclical element built into it. In this respect, federal spending is likely to be more cyclical than provincial and local spending, emphasizing the importance of sound macroeconomic management at the federal level.

The growth in the provincial and local government sectors in Canada in recent decades may have altered the balance and nature of macroeconomic management. The provincial and local government budgets are likely to be less cyclical than the federal one, and the ability of provincial governments to run budget deficits means that in economic downturns, they need not engage in procyclical cuts in spending and increases in revenues, as in the United States, where states face balanced budget requirements. That same ability, however, as indicated above, covers the task of facilitating the growth of public debt, from an already very high level.

Future Direction of Intergovernmental Relations

The federal system in Canada possesses many of the desirable features of a federal system. Spending and revenue-raising responsibilities are appropriately assigned. An important characteristic has been its flexibility; the federation has proven to be remarkably adept at dealing with economic and social change. Two distinctive features of the Canadian system are that it is decentralized with respect to federal-provincial relations and strongly redistributive. Intergovernmental grants serve to equalize the ability to pay for public services and to correct for spillovers. However, the intergovernmental grants system is being cut back, which poses a problem especially for the provincial governments with lower fiscal capacity. The imbalance between their spending and revenues may grow as the federal government reduces its role. How Canada will reconcile this imbalance with its strong desire for equalization remains an unsolved dilemma.

In addition to fiscal issues, in recent years a number of factors are changing the nature of the federation. These issues include the status of Quebec and possibly the western provinces, within the Canadian federal system; and the free trade agreement with the United States, which may shift the pattern of trade from within Canada to between the United States and provinces of Canada (Boothe, 1992).

The authors are grateful to Ehtisham Ahmad, Liam Ebrill, Ron McMorran, and Teresa Ter-Minassian for helpful suggestions and comments.

For example, the government of the province of Ontario announced in early 1977 a plan to take control over the provision of education, at the same time devolving to municipalities responsibility for a number of services, including welfare.

The provincial and local governments are aggregated because the split varies from one province to another. Therefore, the disaggregated figures would be misleading.

For purposes of the personal income tax, the province of residence of a taxpayer is determined by residence on December 31, the last day of the tax year.

There is also a tax on large corporations, which the corporate income tax is creditable against.

Transnational businesses must collect GST and nine provincial retail sales taxes.

While ownership of natural resources was vested in the provinces by the Constitution, it did not clearly specify how rents arising from these resources might be taxed. The federal government’s constitutional claim to revenue arises from its power to control the terms on which interprovincial trade takes place, as well as the power to impose taxes on both the export and import of products.

Since 1972, Canada is one of the few developed countries which has no estate taxes, allowing almost all intergenerational transfers of wealth to escape taxation. As part of tax reform, the federal government vacated this field, opening up additional tax room for the provinces. Tax competition has led to little provincial exploitation of the base.

The provincial and local governments are aggregated because the split varies from one province to another. Therefore, the disaggregated figures would be misleading.

As mentioned earlier, however, the federal government does have concurrent “spending powers” for provincial functions, which it exercises in the form of transfer payments.

Tax transfers are equalized by providing an additional payment to bring the yield of the transferred taxes up to the level specified in the general equalization formula, discussed above.

References

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    BoadwayRobin W. andPaul A.R.Hobson1993Intergovernmental Fiscal Relations in Canada (Toronto: Canadian Tax Foundation).

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